June 29, 2008

Capital Inflows In China

This article on capital inflows in China touches upon issues relevant to the conditions in India too.The issue is that the differential in interest rates between dollar and yuan results in inflows. To maintain the exchange rate, the PBOC sterilizes the yuan and this results in more money in the market and thus inflation. Recent appreciation in the Yuan has fueled more appreciation expectations resulting in exacerbation of inflows. The solution as per the article is to do a relatively larger appreciation of the Yuan which would suck out excess money from the market and also subside future appreciation expectations.

Coming to India, the current rate after the latest hikes is 8.5%. This is a substantial differential with respect to the dollar at 2%. On the top of it, with the WPI sitting unpretty at 11%, the need of the hour is to raise this even further to counter inflation problems. Now raising interest rates is a good thing (though the mismatch between repo and reverse repo rates is not). Thus while rates are being raised to counter inflation, this would increase inflows. With the current policy of sterilization, this would be counterproductive and work to raise inflation. In recent times, the RBI has increased the cash reserve ratio (CRR) a little to tackle the issue (something which China is doing too) but they can do this only so much. Thus unless the RBI changes its policy and starts letting the Rupee appreciate, it will be not very effective in countering inflation. In a normal scenario this would all be good if the RBI just listened. However, with investors starting to get a little bearish about emerging markets, the demand for the Rupee may go down. On the other hand, with recent corrections in the Indian equity markets, FIIs may not feel as bearish after all.